Saturday, September 17, 2011

In an earlier post I covered why the US Federal government should never run a budget surplus, unless there is an offsetting trade surplus. And given that the US runs a large trade deficit, a budget surplus would indeed be harmful. Let me address this topic again in the simplest possible terms. For more details and policy proposals and spending constraints see the original post.

The thing to remember throughout is that a sovereign currency issuer like the US, doesn't face a solvency constraint, i.e: we are not going to run out of dollars. The constraint for government spending is not solvency but inflation. This is covered more in the earlier post.

Why not a budget surplus?

If I give you $20, and you give me $15, you are now financially wealthier by $5, everyone can agree on that. It doesn't matter whether a real good/service was bought/sold or not, as far as financial assets (such as cash, deposits etc:) are concerned, the outcome is the same, you are financially wealthier by $5. If that one transaction is all that you engage in for a given year, you can think of the $15 as your spending for the year, while the $20 is your gross income. Your income less spending is $5. Obviously, your financial position is better off (by $5) at the end of the year. The same also holds true at the macro level, let us take a look at government budget deficits/surpluses to demonstrate this.

We obviously have a budget deficit when the federal government spends more than it taxes. Let us say taxes are $2 Trillion, while government spending is $3.5T, then the government deficit is $1.5T. So where does this extra $1.5T go, does it disappear into thin air as some believe? For simplicity, if we assume for now, the foreign trade balance is 0 (exports equals imports), then every single one of those government deficit dollars ends up in the domestic private sector.In other words the government budget deficit, to the penny, can be thought of as net income for the domestic private sector as a whole.

The deficit spending may be income for an additional federal govt. employee. It may be an additional firefighter or teacher's salary, via a transfer to a state government. It may be income for a private construction worker hired to repair the nation's ailing bridges. It may be retained earnings for a business which provides services to the government. It may be dividends to the investors of that business. It maybe in the form of a tax cut for lower income folks. Or it maybe even wasted on bank bailouts.[1]

Given that inflow is larger than outflow by $1.5T, domestic private sector net financial wealth (financial assets minus debts) as a whole rises by $1.5T.[2] This is not rocket science, it is no different than if I give you $20, and you give me $15, you are now financially wealthier by $5. Similarly, when the government spends $1.5 trillion on top of what it takes out in taxes, domestic private sector net financial wealth (as a whole) rises by $1.5T. Where else can the money ago? To the residents of planet Vulcan? Any spending within the private sector just transfers
financial wealth within the sector. If you buy a $500 Dell computer,
you are financially poorer by $500, while Dell, its employees, investors, suppliers etc: are financially richer by $500. Total private sector net financial wealth has not changed. It just moved within the private sector.

Guess what happens when the government runs a budget surplus. Let us say taxes are $3 Trillion, while government spending is $2.5T, then the budget surplus is $500 Billion. In our example this would be like if I give you $20, and you give me $25, you are now financially poorer by $5. The government is literally taking more out of the domestic sector than it is putting back in. A $500B subtraction to private sector net financial wealth (as a whole). If the budget surplus continues for an extended period, the private sector is literally being depleted.

This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of government budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced government debt by 33%. Guess what followed, the Great Depression. Am I saying that the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing (in deficit) if it is to keep up the same level of spending, when the government budget is in surplus. Actually, it is far more likely that the causation is reverse, a private debt binge is reflected in the government budget as a surplus.[3] The point is that sectors always balance. If the private sector does decide to reduce its debt fueled spending (which is bound to happen eventually), then GDP falls, given that GDP is total spending. As a consequence total income falls due to the fact the someone's spending is someone else's income. And now we have a recession.

On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your net financial wealth by $100K? No of course not, it is a financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets fall? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed, only the composition of your asset portfolio has changed.

For those who are not familiar with the term Current Account, it is mostly the foreign trade balance (exports - imports). It also consists of net factor income. For more details on terms see here. The domestic private sector consists of households, firms and financial firms and its balance is the addition/subtraction to net financial wealth of the private sector in a given period. If the private sector is net borrowing (in deficit), then its balance will be negative; if it is net saving (in surplus), then its balance will be positive.

Economist Scott Fullwiler has compiled actual financial balances of each sector from US national accounts. See figure below. See here for actual examples from US national accounts- see footnotes 1, 3 and 5 in that post for source data. Notice the formula always holds true. Notice how during the late 90s as the government runs a budget surplus and the current account is in deficit (negative), the private sector balance (as a whole) is in deficit for the first time. The same happens during much of the 2000s as the government budget deficit was not large enough to offset the large current account deficit.[3] A private sector deficit is a subtraction to private sector net financial wealth.

Fig 1: US Sectoral Financial Balances (from Scott Fullwiler)
Note: the red line in the chart is shown as positive since the label is Govt. deficit (i.e: negative Govt. balance)

Why does this hold?

For an explanation see economist Stephanie Kelton's article here and here. For an advanced version see this article by economist Scott Fullwiler. For the general reader, I will use a simple example to illustrate this. This is not an explanation, just an illustration...

Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note the keyword NET, Jim may have $2000 of financial assets, and debt of $1500, in which case his net financial wealth is still $500. Also note the keyword FINANCIAL we are only referring to financial assets (such as cash, deposits, stocks etc:). Real assets (such as houses, cars etc:) are not included in the calculation. They engage in 3 transactions during a period of time...

Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10. The sum of the balances is ZERO. This is just a fancy way of saying if Alice gives Jim $10, then Alice doesn't have $10 anymore. Alice's net financial wealth falls by $10, while Jim's rises by $10. The total net financial wealth of the system ($1500) hasn't changed as we would expect, given that sum of the balances is zero. $10 of financial wealth transferred from Alice to Jim.Transaction 2: Bob buys bread from Alice for $20. Bob, now is down $20 (his balance is in deficit), while Alice's balance which was in in deficit of $10 after transaction 1, is up $20, so now she has a surplus of $10. Jim's balance remains at a surplus of $10. Once again the sum of the balances of all three is ZERO, not exactly rocket science here.Transaction 3: Jim buys plumbing service from Bob for $40. Yup still ZERO.

Fig 2: Financial Balances

After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. For any single entity to run a surplus, the sum total of the rest in the system must run a deficit of the same amount. In other words the balances always sum to ZERO, after each transaction, and you can see that in the 'total' column for each row. The total financial net wealth never changes, it still remains $1500. Ever wonder why we have double-entry accounting? For every credit, there must be an equal debit somewhere else, for balances to sum to zero. Anyway in our example...

Alice Bal + Bob Bal + Jim Bal = 0

Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction.

Government Bal + Private Sector Bal + Foreign Sector Bal = 0

Private Sector Bal = -Government Bal - Foreign Sector Bal

If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance. And obviously negative government balance is the same as the government deficit.

Private Sector Bal = Government Deficit + Current Account Bal

Update: The main difference is that Alice, Jim and Bob cannot create new dollars when they spend. The US government as the sovereign issuer of the dollar, creates new dollars when it deficit spends. It can run perpetual deficits, and it has in the past. In the entire history of the US there has only been 5 periods, where we had 5+ continuous years of government budget surpluses. From 1946 to 1981 when we reduced the debt/GDP from 121% to 32%, guess how many surplus years we had? Just 5 surplus (barely) years in total. As you can see in Fig 1, the red line rarely crosses into positive territory. Solvency is not a constraint for currency issuers, inflation is the only constraint.

Conclusions

The sum of sectoral financial balances always equal ZERO. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth. A surplus of one sector must result in a deficit for another.

So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should be accommodating and run an appropriate budget deficit. Some of this will happen naturally due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity (trying to balance the budget) while the private sector wishes to save will not end well. Two sectors cannot net save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance.

If both sectors attempt to net save, that is if the government doesn't pick up the slack for loss of private sector spending, there is obviously now less spending overall in the economy (saving is defined as not spending in economics). Less spending means GDP falls, and as a consequence income falls and the recession worsens. And of course now the sectors balance at a lower GDP level. Since income falls, taxes fall and ironically the government deficit actually gets worse, when the budget cuts are attempted. This is what we are seeing with Ireland and Greece.

The sectoral financial balances model is not rocket science, it is not any more complicated then if I give you $20, then I don't have $20, you have it. What applies for individuals also applies to sectors also. But yet this still has not made much inroads into mainstream economics, although that is slowly changing now. The experiences of countries like Ireland and Greece shows the prescription of mainstream economics, government fiscal austerity, is downright disastrous. Just in Q2 2011 Greece's GDP was falling at an annualized rate of 7.0%. The last chart shows that the government budget cuts starting in 2010 have been the biggest drag on GDP. But yet the calls for budget cuts continue in the Eurozone officialdom. Unless this course is reversed this is unlikely to end well.

Not a single person running our government seems to understand this basic fact as well. The airwaves are saturated with talk about balancing the government budget, when it is not even close to being an issue. It is not even necessary to run a budget surplus to reduce our debt to GDP ratio. The real issue is excessive private debt. When was the last time we heard about that from the congressional talking heads. We hear talk about balancing the budget from even the most liberal faction of Congress (although to be fair, at least they are talking about balancing down the road not in the middle of the recession).[4]. Running an economy based on faith based beliefs, rather than facts is bound to be disastrous.

Updated 9/21/2011: Reorganized things a bit
Updated 3/20/2012: Moved some notes up to the article
Update 4/9/2012: Fixed broken links,fixed some errors

Notes

1. Not all government deficit spending is created equally. Some are more efficient than others. A bank bailout is one of the most inefficient way of spending government resources. 2. Note the key word financial we are only talking about financial assets (such as cash, checking deposits, stocks etc:) in the above examples. Real assets (such as houses, cars etc:) are not included. Financial transactions are a ZERO sum game from a global perspective for users of a currency, that is what we are trying to show here. 3. Or the causation maybe that the private sector gets itself into debt, the sectors balance and the government budget is in surplus, that is more likely. Either way the sectors always balance. The private sector could have chosen to reduce its debt fueled spending, and if another sector doesn't pick up the slack, then GDP falls and the sectors balance at a lower level of GDP, but that is not what happened (except for the 2000 recession). This is what is happening now, the private sector is trying to pare it is debt burden. While the government did pick up some slack, it was only enough for a small growth in GDP. Which, by the way is fading as the government cuts its budget. 4. Update 9/19: 30% of the deficit is due to the recession alone, given that there is less tax revenue and more social safety net spending. The best way to cut the deficit ($4T in 10 yrs) is to do nothing at all with the deficit, get to full employment as fast as possible. But if you must cut it now, best to do it it in a way that impacts the least amount of spending. For example, richer people save rather than spend much of their income, so raising their taxes is less likely to impact GDP that much.

Tuesday, September 6, 2011

You hear this a lot these days from deficit hawks. Our current government deficit spending, will result in a higher future tax burden. So better cut back on the debt now, for the sake of our grandchildren. It is as if these people forget how fractions work - Debt/GDP. Debt by itself means nothing, it only has meaning as a percentage of income. Remember that, US GDP equals all gross domestic income made in the US, given that someone's spending is someone else's income. Thus US debt/US GDP is the relevant figure here. It is as if the hawks assume the denominator (income) will be static forever. Only if GDP is static. What is really static over time is the numerator - debt principal and interest payments. As GDP and inflation grows over time, the original debt remains the same, that is a certainty. So what happens when GDP is higher, income will also be higher (since GDP is income) and thus tax payments will also be higher, all without any new tax increases[1]. So even by their misguided logic, you will have more taxes to cover the same debt (which never changes over time), plus more for new debt issuance. Is there a need for an increased tax burden, in this scenario?

US Debt/GDP history

Take a look at the experience of the US after WWII (1946-1981). Debt/GDP ratio was 121% in 1946, but by 1981 it was just 32%. You would think the Government paid down a lot of its debt. In reality not one cent was paid off. It quadrupled from $271B to $994B. Its not like the government stopped issuing debt after 1946. But yet the debt/GDP ratio went down, because GDP growth far outstripped debt growth. Yet during the same period, the tax burden remained roughly the same, averaging around 17-18% of income (GDP). This idea that the US government is just like a household has to be jettisoned for good. The government does not need to ever repay its debt, it outgrows it. It has only been paid back once (in 1837), but then a depression followed and the government has been in debt ever since. How many households can do that and still function? Does it really matter (even by conventional logic) that the government debt is $100T 30 years from now, when GDP is $200T?

You know what really hurts your grand children. Its not US debt, it is austerity (lack of GDP growth, due to government budget cuts). Generally a recession happens when consumer spending (C) and private investment (I) falls due to loss of confidence in the economy, in this case due to the collapse of the housing bubble. As C and I are components of GDP, GDP falls, and income falls as as a consequence. Less income among the same number of people, and guess what, some people finds themselves out of work[2]. Government spending (G), which is also a component of GDP should rise to prevent a collapse in GDP. Thus, government debt will also rise. Some of this increased spending happens automatically, as social safety net spending increases (unemployment insurance, social security etc:). This may not be enough, ideally the increase should compensate for the loss in C and I[3]. Yes the numerator (debt) increases rapidly for sometime, but GDP growth catches up far faster than if we had chosen the austerity path. Austerity is a double whammy. When the government cuts spending (G) in a recession, not only does GDP fall, but ironically the debt also rises . Why, because GDP is income, and when income falls, taxes fall, unemployment insurance payments rise, thus actually increasing the government debt. The experience of countries like Ireland who embraced austerity early on should show that trying to cut government debt in a recession actually increases the debt. Looks like the US is slowly heading in the Irish direction.

So far I explored this with mainstream logic. The mainstream assumption is that taxes fund government spending. In the case of a state government yes, in the case of a national government under the Euro regime, yes. But for a sovereign issuer of currency, under a floating exchange regime, no. Why does the issuer of dollars, who can create them at will, need to acquire dollars to make payments in dollars? In this type of government (US, Japan, Canada etc:) taxes are a form of inflation control[4], not government income. Yes currently there are restrictions on how the government spends, but they are a self imposed political straight jacket, they are certainly not economic in nature. They should be repealed so we can unleash the full potential of our economy. The title claim makes even less sense, when you take this into context. The only real economic restriction on government spending is inflation.[5] Plus lets us not forget that a liability (government debt), is in an asset to some one else. 69% of US government debt is owned by American households and institutions. If you own treasuries they are your assets not your debt. So if anything your grand children are inheriting interest paying assets not debt.

Notes:

1. I made things a little simpler so it is easy to follow. See the Question 5 section here for more detail, on why government budget surpluses are not needed to reduce the debt ratio. 2. Again I simplified things slightly. For more detail on recessions see here.3. Not all government spending is created equal. Some spending is very inefficient, such as tax cuts for rich, or giving tax cuts to business and hope they hire people. On the other hand direct government spending on creating jobs is far more efficient. While the modest US stimulus of 2009 did help in GDP growth when it was still active, it didn't help as much (it still helped) in lowering the unemployment situation. It was far too small and contained too much inefficient spending. Direct government spending on jobs has not been tried since the 1930s when it was highly successful. The GDP growth rate then, averaged 10% and employment growth was 750k jobs/month (population adjusted). 4. In this example I am referring to possible inflation due to government deficit spending. There are different types of inflation. For example supply issues, caused by real shortages or speculation. The latter type of inflation is what is occurring now in the energy and food markets.5. There is a range beyond which government spending will cause more than the desired inflation. This range is much wider in recessionary times, while it is much narrower at times of full employment. But in no way is the money supply proportional to price inflation. It maybe during times of full employment, but otherwise unlikely.

Friday, August 5, 2011

Few day ago I posted on why US government debt is not debt? I wanted to add a couple of things. At no point along the chain from your purchase of a Chinese good to China's purchase of treasuries does anyone ship wheelbarrows full of cash to China. This all happens electronically within the banking system. The nature of money is to function as a valueless token that facilitates the exchange of real goods and services. We think of money as a physical thing with value, but it is just pieces of papers with dead presidents on them. Only paper and metal money existed in the past, due to technological limitations. But today, most money exists only as digital entries in bank data centers. Think how much of your financial wealth exists in physical form? Unless you are a mattress stuffee, perhaps just the dollars in your wallet. The rest, the lion share, exist only as entries in bank databases. There is nothing wrong with this system, as long as there is proper accounting and transparency. The advantage is electronic dollar tokens makes day to day transactions very convenient and efficient. Which is more convenient and efficient - snail mail or email? Same applies for physical vs digital money.

So when you buy a $100 Chinese product with your debit card, your bank account is electronically deducted by $100 while the Chinese company's bank account is credited by $100. The end result is that, two database entries change in opposite directions at the respective banking data centers. Your account database entry by -$100, the Chinese company's by +$100. That's really it, there are no physical transfers. It is like a score keeping system, where dollars are like points. Same at the other end of the chain. When China buy $10B of treasuries, its reserve account at the Fed (checking account) is deducted by $10B and its treasury account is credited by $10B. That's it, two numbers changed in opposite directions at the US government data centers.

As an analogy, think of what happens when you transfer $1000 from your checking account to purchase a CD. Once again two entries change in opposite directions,. The $1000 is locked up for a period of time in the CD, but it earns interest in return. This is similar to what happens when China buys treasuries. Now here is the question when you transferred money from checking to the CD did the bank get more money?

Now what happens when the treasury bond matures? China's treasury account is deducted by $10B and its reserve account is credited by $10B. All the US government has to do is once again update two entries in opposite directions. Being the issuer of the currency in which the debt is issued, there is no limit to the amount which the government can credit bank accounts in that currency. On the other hand a currency user (which is every one else) needs to have money coming in before it can go out. There is no economic reason by which the US will fail to make a payment. All it does is update numbers in a database. If it does issue a check, then the updates happens when the receiver deposits the check. Really the only way the US government could fail to make a payment is for voluntarily self-imposed political reasons.

The advantages of sovereign currency issuance

There are many reasons why it is advantageous, that our government is a sovereign issuer of currency.. One is that we don't want to end up like Greece, susceptible to the mercy of the bond markets. Greece doesn't have it own currency, so it really does rely on the bond markets for operating funds. It is like a state government in the US. Its 10yr bonds have an yield of 15.24%, its 2 yr bonds are at 33.64%!! (an inverted yield curve). In other words Greece's borrowing costs are ridiculously high. The so called bond vigilantes are pummeling Greece, they view it as a sub prime borrower. Greece probably may have already defaulted if it doesn't keep getting bailed by the ECB (European Central Bank) the issuer of the Euro.

On the other hand, US 10 yr bonds are at 2.56% and 2 yrs bonds are at 0.29%. 10 yr bonds in Japan, with a debt to GDP ratio far higher than Greece, is even lower than the US at 1.01%. Its 2 yr bonds are at 0.14%. There is not going to be much bond vigilantism against a currency issuer, an entity than can create money out of thin air, that is unless the lobotomy party, err.. I mean the tea party gains power and prevents the Fed from acting. There is a saying in the bond markets, "Don't fight the Fed". Investor Cullen Roche has compiled a chart here, which shows there is high correlation between Fed policy and treasury yields. Even the 30 yr bonds show an 87% correlation. In other words, the US is not at the mercy of the bond markets, even given our self-imposed political straight jacket. The Fed may be incompetent at a lot of things, but controlling interest rates is something it does very well.

Additionally we established in Part 1, that even if not at single person buys US bonds, it doesn't matter. As the sole issuer of dollars, does the US really need to get dollar loans to make payment in dollars. Even with current political restrictions the Fed can buy/sell treasury bonds as needed to support policy, it just can't buy it directly from the treasury.

So what is the US bond market really then? It is a really safe place to put your savings. That is how the bond market seems to view it. Take a look this chart from Cullen Roche reprinted below. Even in the middle of last month's debt ceiling debacle the yield was dropping. The yield drops when demand for the bond increases, investors are willing to accept a lower yield for safety. Every time there is economic head winds, investors dump their equity holdings to rush for the safety of treasuries. And when the economic news is better, they tend to leave. Bond investors doesn't seem to concerned at all about US government debt level. Quite opposite what the political class tells us, isn't it. When in doubt follow the money, and this chart below from the Roche article says more than a thousand words. So now can we stop worrying about the debt and focus on jobs.

Update 8/6: The S&P downgrade may or may not temporarily roil the bond market, no way to know how the hive mind (err.. market) will react, but in the end it should be a non-event. As some observers say, what should be more of a concern is whether there will be a domino effect into municipal bonds or foreign arenas. Downgrading a currency issuer, who's entire debt is in the same currency is meaningless. Japan has been downgraded many times but its yield on 10 yr bonds still remains low at 1.01%.

Monday, August 1, 2011

First of all, treasuries are not your debt. If you own US treasuries they are in your asset column. You get interest if you own treasuries, you don't pay it, that much should be obvious. They are really your savings. Secondly, 69% of US "debt" is owned by American households and American institutions. 58% of the 69% (or 39% of the total) is owned by federal government agencies (the Social Security Administration etc:), i.e: money the government owes itself. Foreign ownership is just 31%. In other words most US treasury interest payments go to Americans. The debt is essentially money the government owes us, we don't owe anything to anybody. We hear jokes on how China is going to kneecap us if we don't pay up. Even if we hold the incorrect conventional view that US treasuries is debt, guess how much China owns - about 8%. Perhaps, we should be kneecapping ourselves. Japan owns about the same share as China, but you never hear about them "repossessing" America. All this type of debt talk is either outright ignorance or fear mongering plain and simple.

Is China lending to us

Essentially no, China's treasury holdings are a function of our trade deficit rather than our budget deficit. When you purchase Chinese goods, do you use dollars or Chinese currency? Dollars obviously. Given that we have a trade deficit with China, Chinese companies end up with excess dollars. Last quarter US exported $36B to China while China exported 650 CNY ($101B) to the US , Chinese companies as a whole have a net addition of 65B US dollars to their bank accounts. They can now use these dollars to buy dollar denominated assets such or US treasuries or US buildings , but then again you need two parties for a sale. Just because somebody wants to buy buildings doesn't mean they are for sale. In actuality what Chinese companies tend do is exchange dollars with the PBOC (Chinese central bank) for their own currency, and thus these dollars end up in China's reserve account (checking account) at the Fed. What will the PBOC do, sit on these dollars that earn no interest? Guess what they do, the vast majority of these dollars go into the purchase of treasuries that earn interest. See economist Randall Wray's post here for more details In Fig 1 from Prof. Wray's post notice how China's share of US treasuries increases as we run ever larger trade deficits with them in the 00's. Click to enlarge.

Fig 1: Foreign holdings of US treasuries (2000-2010)

What should be clear now is that China's ownership of US treasuries is a function of the US trade deficit. Here is additional data. Does anyone think it is coincidence that the two countries with we have the largest trade deficits (China & Japan) have the largest foreign holdings of US treasuries at 47%? China can threaten all they want, but as long as they choose to run a trade surplus with us, they are going to end up with dollars. Sure they can buy US stocks instead of US treasuries, but historically they have not shown an appetite for that kind of risk[1].

Why US debt isn't debt

And given that the government is the issuer of currency, why is there even a need to issue debt? Let us say you had your own currency, that you could issue at will and it is accepted everywhere in exchange for goods and services. Will you ever fail to make a payment for lack of funds? What does debt mean in this case? Do you ever need to take on debt to make your payments? For households, state governments, business and even some European governments (in the Euro regime) like Greece, and even Germany, bond issuance is indeed debt, as they are currency users. But for a sovereign currency issuer like the US, Japan, Canada is bond issuance really debt?[2] Then what is it?

Debt issuance is gold standard relic, back from the 19th century, when economists lost the centuries old understanding of the nature of money, and decided to tie the output of the US economy to mines in South Africa. The gold standard is dead and gone for 40 years, but yet policymakers run the country as we are still in one. This is a completely unnecessary straight jacket in a modern fiat system. An issuer of money can never run out said money, solvency is never a restriction, thus the concept of debt is meaningless. The only real restriction on government spending, is inflation. That type of inflation is highly unlikely to happen right now, as we have high unemployment and large under utilization of productive capacity - in other words the metaphorical factories are sitting idle due to lack of demand for their products. Additional money injected (income) into the private sector right now, is far more likely to bring these metaphorical factories online than drive up prices.

Even though the US government doesn't have solvency restrictions, there are a lot of unnecessary political restrictions. They are political in nature, not economic. What we have is the worst of both worlds. A Fed that can issue money at will, and a Treasury which cannot. A Treasury which has accountability and transparency, and a Fed which has none. That is how you end up with a corrupt Fed chairman bailing out banks to the tune of $16T (yes trillion) behind closed doors. These kind of the things shouldn't happen if we are still to remain a democracy. The best of both worlds, would be a Fed and Treasury that have no restrictions in currency issuance with full transparency and accountability.

Why issue treasuries then

But that doesn't mean we should not issue treasuries. They do have other functions. For example the Fed exercises absolute control of the short term interest rate, and is willing to defend it with open market purchases/sales of treasuries. While there is market variability on the longer term treasury yields, that happens only because the Fed allows it. The Fed may choose to purchase a whole lot more of those treasuries in the open market, thus driving down yields. The Fed could purchase all of it, if there is not a single sale in the open market, as we established a currency issuer doesn't really to need to get its own currency from others. But there is no danger of that happening anytime soon, the demand for US treasuries generally exceed supply by 3:1 at treasury auctions. In addition, treasuries represent a risk free savings for the private sector. It is like a welfare program, as we established that the government doesn't really need your funds to operate. As Cullen Roche says the debt clock isn't really a debt clock, it is a national savings clock.

So in conclusion, we don't really have a debt problem. As a currency issuer, we are not going to fail to meet our debt payments, which by the way is in the same currency. We are not Greece, they cannot issue the Euro. The only way we could default is if we choose to do so for self imposed reasons (like the debt ceiling). We are not burdening our grand children with US debt, if anything they are inheriting interest paying assets.

Notes

1. Update 8/14: What happens if China stopped holding on to the dollars and dumped them into the foreign exchange markets, well then the dollar falls due to increased supply. Essentially, 1 USD=6.39 CNY right now, but that ratio falls. US trade deficit falls (after it temporarily increases). Why, because now Chinese goods are more expensive in the US and their demand drops, while US goods are less expensive in China and their demands increases. Our trade deficit becomes ever smaller as China continues to dump dollars. So China can either hold on to the dollars (in the form of treasuries) or dump them in the forex markets killing their export industry. So if anything we have China over a barrel, not the other way around. China used to maintain a peg on the dollar (thus subsidizing its export industry), by holding/buying dollars. If they don't hold/buy enough then the dollars falls.2.Update 8/14: In reality, the implementation of this no treasuries scenario requires IORs (Interest payments on bank reserves), as economist Scott Fullwiler says. The IOR scenario is functionally identical to treasury bills, and is necessary for the Fed to maintain control of the interest rate, when there is no treasury issuance. And it is no more inflationary than T-bills. In fact since 2008 the Fed has been doing IORs also by adding bank reserves on its liabilities side, to facilitate its balance sheet expansion. Clearly this has not been inflationary, despite many hyperbolic predictions.

Sunday, July 24, 2011

The Federal government should never run a budget surplus, unless there is an offsetting trade surplus. And given that the US runs a large current account deficit (mostly a trade deficit), a budget surplus would indeed be harmful. This easily verifiable fact championed by economists of an MMT stripe [1], seems to elude those in charge of national economic policy. All the recent misguided talk about fiscal austerity among all political stripes, shows how sub-optimal or even damaging this can be. The question is, should we run our economy based on pre-conceived notions or actual facts? The source articles, on which this post is based can be found here (a wonkish post by MMT economist Scott Fullwiler) and here.(by Edward Harrison, who frequently guest posts at the top financial blog Naked Capitalism)

Now let us take a look some data from the US and Eurozone. h/t Scott Fullwiler and Financial Times for these images based on US Government and OECD data. Additional images for the Eurozone and Japan can be found in the Harrison article.

For those who are not familiar with these terms see here for definitions and examples. Current account is essentially the negative of the capital account. And negative government balance is the government deficit. So we have...

US sectoral balances for the last 60 years have been compiled into an excel spreadsheet by economist Stephanie Kelton, for easy reading. And here is the link to her original article for further reading. It should be clear that in all cases, whether a fiat system or not, when the government runs a budget surplus provided it is not offset by a current account surplus then the private sector is running a deficit, i.e: this is a subtraction to private sector net financial wealth. The inverse also holds true. If the private sector decides to net save (run a surplus), and if the current account is in deficit, then the government sector should run a budget deficit that balances the equation. If it embraces austerity instead, GDP falls, and thus private income falls as a consequence. The sectors will balance regardless, it is a matter of what level of GDP you want them to balance. This is the exact scenario we have been facing in the US and Euro zone since the beginning of the Great Recession.

Why does this hold?

For those who are economics inclined see the Scott Fullwiler article for an explanation. For the general reader I will explicitly spell out what Ed Harrison is stating in his article. I have been sending the source links to people for a year, what I found is many aren't aware that total financial balances always equal zero, even after reading those articles. So forgive the simple example illustrating just that, it maybe necessary for some. This is not an explanation, just an illustration..

Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note we are only dealing with financial assets balances here not real assets.

Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10
Transaction 2: Bob buys bread from Alice for $20.
Transaction 3: Jim buys plumbing service from Bob for $40

After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. In other words the balance for all three always sums to ZERO, after each transaction. Also note, for any single entity to run a surplus, the sum total of the rest must run a deficit of the same amount.

Alice Bal + Bob Bal + Jim Bal = 0

Table 1: Financial Balances

Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups as Harrison was stating. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction, see above figures.

If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance.

Private Financial Bal = Govt Deficit + Current Account Bal[2]

What is a govt budget deficit?

To hammer the point home even more, let us take look at budget deficits. We obviously have a budget deficit when the federal government spends more than it taxes. So where does this extra deficit money go, does it disappear into thin air? If we assume the current account balance is 0 (exports=imports), then every single one of those government deficit dollars ends up in the private sector, whether it be an additional government workers salary, or the salary of a private employee hired to build railway infrastructure, or a corporate balance sheet from sale of computer equipment. In other words the deficit is income for the private sector. Thus, private sector net wealth as a whole increases by the exact same amount as the federal government deficit. The deficit is essentially creating new money for the private sector.

In the case of the USA, we do have a current account deficit so significant portion of the government deficit dollars, ends up overseas also. Does anyone think it is coincidence that the two countries (China & Japan) with which we have the largest current account deficits (mostly trade deficits) have the largest dollar holdings in the form of treasuries? Nevertheless it should be clear, a federal government deficit increases the net financial wealth of the private sector, provided it is not offset by a current account deficit.

On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your financial wealth by $100K? No of course not, it is an financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets change? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed.

What happens if the government runs a surplus. Obviously, it is literally taking more money out of the private sector than it puts back in - a subtraction to the net financial wealth of the private sector. If the budget surplus continues for an extended period, the private sector is literally being depleted. This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced the debt by 33%. Guess what followed, the Great Depression. Am I saying the the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing when the government budget is in surplus.

What are the constraints for deficit spending?

The only real constraint for deficit spending is the total output of the national economy. Spending beyond the economy's production capacity is what results in inflation. Our economy is well below capacity right now. The metaphorical factories are sitting idle. Which is why we have high unemployment. So right now large budget deficits are not a problem. As unemployment decreases, tax revenues increase, unemployment insurance payments decrease, and thus much of the deficit takes care of itself. Note MMT economists are just talking about this one type of inflation. Inflation may still happen due to other issues, such as supply constraints - for example oil supply disruptions or excessive commodity market speculation. Due to the fact the oil is a commodity, other prices may rise. But that type of inflation if it does happen, it would happen regardless of whether we have large deficits or not.

Despite conventional wisdom solvency is not a constraint. Our government is the sovereign issuer of our own flexible exchange rate currency. How can an entity with its own currency ever fail to make a payment in that currency, other than through self-imposed limitations? If you had your own currency that you could issue at will, and your currency is accepted everywhere in exchange for goods and services, will you ever fail to make a payment in the currency. Would you ever need to issue debt, what does debt issuance even mean in this case? But yet that is the dominant conversation these days. Solvency considerations and government debt issuance are gold standard relics. This might seem shocking for those not familiar with MMT, I will address this in a future post. While everyone is aware that we have a fiat system, national economic policy is crafted as though we are still in a gold standard system.

State and local governments, and even European governments (such as Greece, Ireland and even Germany) do indeed have a solvency constraint, as they do not have sovereign control of their currency. On the other hand, governments like Japan, USA, Canada, Australia are true fiat systems, and they do not have a solvency constraint. Japan as of now has a debt level at 200% of GDP and yet their 10yr government bonds are going for just 1.3%. Mainstream economists have been predicting the demise of Japan for the last 20 years, due to high debt levels, high inflation, and high government bond rates, none of which has come to pass. That is because they still base their views on an archaic system. Are MMT economists saying these governments will never default? No, they are saying there will be never a reason for them to default. Lawmakers may still have a collective lobotomy and choose to do so. Japan may choose to default next week, but there is not a single economic reason for them to do that. The US may choose to default if the Republicans don't raise the debt ceiling, but these are self-imposed constraints. It would be about as brilliant as taking a gun and shooting yourself in the leg one day, randomly.

Conclusions

The sectoral financial balances always equal zero, regardless of whether we are in a fiat system or not. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth.

So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should accommodate that and run a larger budget deficit. This will naturally happen due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity while the private sector wishes to save will not end well. Two sectors cannot save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance. So given that now there is less spending overall (in economics saving is defined as not spending) a further worsening of the recession occurs. If you are familiar with the concept that all spending (GDP) in a country, is all income made in that country, why this happens should be clear. Thus, as spending drops private sector income also drops. Ironically, austerity actually makes the government deficit worse, as government revenues drop due to loss of private income. This is exactly what is going on in many European countries that have chosen austerity. See Ireland, Estonia, Greece. Take a look at Ireland's austerity program begun in 2008, and see how devastating it has been. The GDP finally stopped dropping (for now), but since the article was written unemployment increased another 1% to 14.2%.

The main advantage a true fiat system like ours has over Ireland, is that we have no solvency constraints in running a budget deficit, so austerity makes no sense at all.The only real constraint in deficit spending is inflation. But, our economy is well below capacity, the metaphorical factories are sitting idle, so any additional money injected into the economy is highly unlikely to cause inflation. As unemployment falls, tax revenues rise and unemployment insurance falls, much of the deficit takes care of itself. Approximately 30% of the current deficit is due to the recession alone.

Just any deficit spending probably may not be optimal. If the target is the financial sector(bailouts)it is relatively useless. Even a conventional pump-priming stimulus, (while it does improve things) is unlikely to be that very efficient. MMT economists would say, the best way to reduce the long-term deficit is not worry about the deficit right now, but aim government resources at targeting unemployment directly. The best month the private sector had this year was 200,000 jobs/month. Seems significant, but that is not going to cut it. If we add 200K jobs/month it will take us 11 years to get to 4.5% employment according to this study. If 300K jobs/month then 5 years, if 500K jobs/month then only 2.5 years. Private business are running record profits, but yet they are not hiring, as their hiring decisions are based on consumer demand, which is still very weak, and leaning towards a double dip The government should fill in the employment gap directly, (not through indirect stimulus), if we want a quick recovery. We have a lot of idle construction, why not put that to good use (at least temporarily) repairing the nation's crumbling infrastructure. From 1933-37 this approach was highly successful, when a population adjusted figure of 750,000 jobs/month was the norm, GDP growth averaged 10%/yr and unemployment fell from 23% to 10%. That is, until FDR decided to massively cut the deficit in 1937. Does it is seem that any politician actually learned from this experience? Yeah a government role in job creation conflicts with the ideology of some, but should we run our economy based on unverified ideologies or reality?

Notes:

1. MMT or Modern Monetary Theory is an explanation (not just a theory) of how a modern fiat/credit monetary system really works. And that is what we have in the US and most other major economies except for those European countries under the euro regime.2. We could have additionally split the private sector into two, whatever is suitable for analyzing financial flow. This maybe even more relevant. In my view, what is really the aim of economic policy but to increase the net financial wealth of the household sector. What is important to know is that the sectoral financial flows always balance, regardless of how many sectors we choose to use. For the household sector to be in surplus the sum of the rest must be in deficit by the same amount. Govt Fin Bal + Household Sector Fin Bal + Business Sector Fin Bal + Foreign Sector Fin Bal = 0

Sunday, March 13, 2011

Private Financial Balance (aka Private Net Savings): Here is a good definition from economist Scott Fullwiler. "Private sector financial balance or Private sector net savings is the addition/subtraction to net financial wealth for the private sector in a given period. If the private sector is net borrowing, then its balance will be negative (deficit); if it is net saving, then its balance will be positive (surplus)".[1][2]

Government Financial Balance: Obviously, when negative we have a budget deficit, if positive we have a budget surplus.[3]

Current Account Balance: The current account is the sum of the balance of trade (exports - imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). In the US its largest component is the trade balance (exports - imports). For example, if we import $50 of goods and export $30 of goods our current account balance is in deficit by $20 (assuming other current account components have zero balances).[4][5]See here for more.

Capital Account Balance (aka Financial Account Balance): The capital account is the change in the foreign ownership of domestic assets minus the change in domestic ownership of foreign assets. In the US it is indeed mostly the financial account (which deals with only financial asset net changes). It is essentially the negative of the current account balance. In our example, the foreign sector as a whole now has a $20 surplus, with which they can buy dollar denominated assets such as US Treasuries or US buildings. So there will be a net change in foreign ownership of US assets by $20. In reality though the current account and the capital account balances don't exactly equal due to differences in accounting conventions and exchange rate fluctuations.[4]See here for more.

Examples

Now let us take a look at some examples using the sectoral balances equation. Real world data fits pretty close to the predicted equation in every case.

If we look at data for 2009. The private balance is in surplus or the private sector is net saving, as the large government deficit more than offsets the current account deficit. This would be an addition to private sector net financial wealth by $1244 billion or 8.9% of GDP.

1243.7B = 1621.7B + -377.4B (as % of GDP: 8.9 = 11.6 - 2.7 )

If we look at data for 2006. The private balance is in deficit or the private sector is net borrowing, as the government deficit was not big enough to offset the large current account deficit. This would be a subtraction to private sector net financial wealth by $509 billion, 3.8% of GDP.

-508.9B = 291.6 + -798.4B (as % of GDP: -3.8 = 2.1 - 5.9)

If we look at data for 2000. The private balance is once again in deficit as the government is running a surplus and the current account is in deficit. Once again we have a subtraction to private sector net financial wealth by $557 billion, 5.6% of GDP.

-557.3B = -146.6B + -410.4B (as % of GDP: -5.6 = -1.5 - 4.1)

This data shows why the federal government should never run a budget surplus unless it is offset by a current account surplus.

Notes

1.See Line 37 here for private balance. Note that the definition here is NOT the same as in Line 3, see notes 2 . 2. Line 3 is disposable income minus final consumption expenditures, it does not include investment expenditures on physical capital. For example, household sector (a part of the private sector) final consumption expenditures is the 'C' component of GDP. New housing purchases are not included in 'C', they are counted under investment 'I'. So Line 3 minus net physical capital formation (such as new houses) due to investment spending will give us the private financial balance.3.See Line 40 here for government balance4. Current, capital, financial accounts have different meanings in different contexts in national accounting. Here we are talking about foreign transaction current account, foreign transactions capital account etc:5.See line 29 here for US current account balance

Friday, March 11, 2011

A country's GDP is all gross domestic income made in the country. Those with some economics training may already know why this is so, but I would presume that most people are not aware of this. If you look at US gross domestic income (GDI): individual wages & salaries + corporate profits + proprietor income + rental income + net interest + indirect taxes on production + consumption of fixed capital [1][2], that figure comes out to be the same as the GDP. Not exactly the same, no measurement is perfect, they are usually within 1%. In 2009 US GDI was $13.862 trillion, while GDP was $13.939 trillion.

What is GDP?

GDP or Gross Domestic Product is the market value of all final goods and services produced within the borders of a country in a given period. There are 3 approaches to calculate GDP, the most well known being the expenditure method, i.e: measure all expenditures (spending) in the economy: For spending to occur on a product, obviously it has to be produced. Thus by measuring total spending we can measure total output or production. See wiki for additional info.

GDP = C + G + I + (X - M)

C: Personal consumption expenditures: Total consumer spending on final goods and services. Makes up the lion share of US GDP at 71% in 2009G:Government consumption expenditures and gross investment: Total government spending on final goods and services. Transfer payments such as social security and unemployment are not counted in G. A social security check is spend by the consumer who receives it, so it falls under C. Makes up about 20% of US GDP.I: Gross private domestic investment: Mostly business investment in physical capital (eg: software, factories, equipment). Financial investment is never counted, as that is saving [3] [4]. Also includes new residential housing purchases, and changes in private business inventories. Makes up about 12% of US GDP in 2009, typically though it is closer to 16% during normal economic times.X: Exports are good/services produced domestically but not consumed domestically. They must be added to get a true account of domestic production. M: Imports are goods/services not produced domestically but consumed domestically. They are already included in C, G or I, so it must be subtracted from GDP. Since the US runs a trade deficit (X-M) is negative and thus takes away from GDP at -3%.

GDP as gross domestic income

GDP is also total gross domestic income, as one's spending is someone else's income. If you buy an IPod from Apple, that money isn't lit on fire. It is income for Apple's employees, management, investors, suppliers etc:. Not only are you a consumer, you are a producer. Your income comes from your role in the production of a good or service. In other words the spending of another entity on that particular product results in your income. And this is true for all income earners. Thus all spending in the economy is also all income generated in the economy.

As a simple illustration, let us look at an economy with just 2 people. Let us say Jim hunts fish, and Alice farms potatoes. During the year Jim "produces" 100 fish and sells them to Alice for $5 each. Alice "produces" 200 potatoes and sells them to Jim for $2 each. The total GDP for the year in this economy is 100 X 5 + 200 X 2 = $900. The total gross income made by Jim is $500, by Alice $400, for a total of $900. Of course the gross income minus spending is much smaller or negative in the case of Alice. But the point is the Alice's spending is Jim's gross income and vice versa. The same is true in real world economies. The spending of consumers, business and government is income for other business and consumers. See pages 2-5 here (pdf) for an excellent explanation, from the US Dept. of Commerce.

Notes:

1. Consumption of fixed capital (economic depreciation) is included, as both GDI and GDP are gross figures. Depreciation is essentially accounting for the portion of physical capital that wears out during a given period. For Net Domestic Income (NDI) and Net Domestic Product (NDP) depreciation is subtracted. 2. Note that transfer payments such as social security income and welfare payments are not included in GDI. Given that they are transfers, this would result in double counting. Only incomes generated from the production of goods and services are included.3. In economics saving is defined as not spending (deferred consumption). By default any income made is saved, that is until it is spent. Putting your money under a mattress, in a bank account or financial investment is all considered saving, as all these activities takes money out of the real economy. Now if money leaves financial institutions through other channels it may result in spending in the real economy, unless it is saved again. 4. Let us take stocks as an example to illustrate the saving concept. Buying stock is a transfer of claims on future production, not actual production. Which is why financial investment is never counted in GDP, as GDP is measure of production. Vast majority of stock purchases are third party transfers. If you buy IBM stock, you purchase it from a third party who already owns the stock, not IBM. Money never leaves the financial system. Only on an new share issue does IBM get any financial capital. But even this is not counted in GDP, as IBM may choose to retain this money or buy financial products, both of which are saving. Only when that money is actually spend in the real economy does it count towards GDP.